This Week In Securities Litigation (March 13, 2009)
Criminal securities fraud cases dominated headlines this week, with Ponzi scheme king Bernard Madoff pleading guilty to an eleven-count criminal information after which he was had his bail revoked and was sent to jail pending sentencing. In addition, the former head of regulatory affairs for Biopure Corporation pled guilty to obstructing an SEC enforcement action by lying about his health, while the former head of KB Homes was indicted on criminal charges based on option backdating charges.
In civil cases, the Supreme Court agreed to hear an appeal which will construe Section 36(b) of the Advisers Act and determine what plaintiffs must allege and prove to challenge the fees of a fund adviser. Cornerstone Research reported that in securities class actions the number of settlements and their amount declined in 2008 compared to 2007. And, the SEC was named as a defendant in an action alleging violations of the trademark laws.
The SEC filed a series of cases, including three alleging financial fraud, one based on option backdating and another claiming that brokers paid kickbacks to hedge fund employees to obtain order flow. The Commission also filed a settled administrative proceeding against Merrill Lynch for failing to have adequate procedures to protect the non-public information of institutional customer. The SEC filed three more Ponzi scheme cases.
U.S. v. Madoff, Case No. 1:09-cr-00213 (S.D.N.Y. Filed March 10, 2008). Bernard Madoff, creator of the largest Ponzi scheme in history, pled guilty to eleven felony counts in a criminal information. Mr. Madoff, who reportedly is not cooperating with the government, pled guilty to counts of securities fraud, mail fraud, wire fraud, money laundering, making false statements and making false SEC filings. Following the plea, Mr. Madoff was remanded to jail.
In U.S. v. Richman, No. 08-10282 (D. Mass. Filed Sept. 23, 2008), defendant Howard Richman, the former head of regulatory affairs of Biopure Corporation, pled guilty to making false statements and obstructing justice in an SEC action. The charges are based on false claims Mr. Richman made to a federal judge claiming that he was terminally ill with colon cancer and could no longer participate in the SEC’s ongoing civil enforcement action against him and the company which is discussed here.
U.S. v. Karatz, Case No. 09-203 (C.D. Cal. Filed March 5, 2009) is criminal options backdating case filed against former KB Home CEO Bruce Karatz. The indictment contains 20 counts alleging securities fraud, wire fraud and making false statements to the SEC. Previously, the former head of human resources of KB pled guilty to conspiring with Mr. Karatz to obstruct the SEC’s investigation. See also SEC v. Karatz, Case No. CV 08-06012 (C.D. Cal. Filed Sept. 15, 2008) (settled options backdating case in which Mr. Karatz consented to the entry of a permanent injunction, the payment of about $6.7 million in disgorgement and interest, the payment of a civil penalty of $480,000 and a five year officer director bar).
Supreme Court: The Court agreed to hear Jones v. Harris Associates, L.P., No. 08-586 (S. Ct. Filed Nov. 3, 2008). The case presents a significant question for the mutual fund industry. It will determine what shareholders must established when bringing suit under Section 36(b) of the Investment Company Act claiming that the fees paid the investment adviser are excessive.
The decision essentially requires that the shareholders prove deception to claim a Section 36(b) breach of fiduciary duty based on a claim of excessive fees. As Judge Easterbrook stated, writing for he court: “A fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” The federal securities laws rely primarily on disclosure and “then allowing price to be set by competition in which investors make their won choices.” Those investor choices can be made by switching funds. Jones v. Harris Associates L.P., 2007 WL 627640 (7th Cir. May 19, 2008).
Prior to Jones, the leading decision was Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982). There, the Court held that the concept of a fiduciary duty under Section 36(b) reflects the reality of the situation involving an investment company and its adviser. In that context, a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg has been followed by the Third and Fourth Circuits. Krantz v. Prudential Investments Fund Management LLC, 305 F.3d 140 (3rd. Cir. 2002); Migdal v. Rowe Price-Fleming International, Inc., 248 F.3d 321 (4th Cir. 2001).
The SEC: The SEC was named as a defendant in an enforcement suit. CaseWare International, a Canadian accounting and auditing software maker, filed suit to enforce its trademark, claiming it was infringed by the SEC. At issue, is the use of the mark “IDEA.” The IDEA system, being rolled out by the SEC to replace EDGAR, is part of the Commission’s effort to increase investor access to company financial data. CaseWare International, Inc., v. SEC, Case No. 4:09-cv-00686 (S.D. Tex. Filed March 9, 2009).
Settlements: The number of settlements in private securities damage actions, as well as the amount of the settlements, declined in 2008 compared to 2007, according to a new report from Cornerstone Research. In 2008 the number of settlements dropped to 99 compared to 110 in 2007. When the largest settlements are excluded the average settlement in 2008 dropped to $31 compared to $35 million in 2008. The decline is more dramatic if all settlements are included. However, the $3.2 billion Tyco settlement in 2007 tends to skew the statistics, particularly since there were no billion dollar plus settlements in 2008.
The median settlement in class actions led by public pension plans continued to be significantly larger than those in cases with non-institutional lead plaintiffs. The median settlement in cases lead by a pension fund was nearly $15 million, while it was less that $7 million in the cases not led by a pension fund. Overall however, the amounts still declined compared to 2007 when the amounts were $18 million for public pension plans and $6.6 million for others.
Finally, the practice of filing a derivative suit following the initiation of a class action also declined in 2008 compared to 2007.
SEC v. MedQuist, Inc.: This financial fraud case resulted in three enforcement actions, two of which are settled. The complaint alleges that from 1999 to 2004 the company misrepresented in press releases and earnings calls the basis for its apparent success. That success was attributed to disciplined and conservative business practices, when in fact it resulted from inflating customer bills to increase revenue and profit.
The company settled by consenting to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions. SEC v. MedQuist, Inc., Civil Action No. 09-CV-2298 (S.D.N.Y. Filed March 12, 2009). A second action was filed against John Donohoe, a former director of the company as well as its former president and COO. Mr. Donohoe also settled with the SEC. Mr. Donohoe consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions. He also agreed to pay a civil penalty of $75,000 and to the entry of a five year officer director bar. SEC v. Donohoe, Civil Action No. 09-CV-2298 (S.D.N.Y. Filed March 12, 2009).
A third action was brought against Brian Kearns, the former CFO of the company, and Bruce Van Fossen, the former controller. This action, based on the same scheme alleged in the company complaint, charges that the two defendants violated the antifraud provisions and aided and abetted the filing and internal control violations by the company. This case is in litigation. SEC v. Kearns, Civil Action No. 09-CV-2296 (S.D.N.Y. Filed March 12, 2009).
SEC v. Travis, Civil Action No. 09 CV 2288 (S.D.N.Y. Filed March 12, 2009) is an action brought against two brokers, David Baker and Daniel Schreiber, the broker dealer with which Mr. Schreiber was associated, Granite Financial Group, and two employees of a hedge fund investment advisor, Nicholas Vulpis and Brian Travis. The complaint alleges that from 2003 to 2005 Messrs. Travis and Vulpis, employees of investment adviser JLF Asset Management LLC, solicited and accepted bribes from the broker defendants. In exchange for the bribes, the two investment adviser employees directed order flow to the brokers. The complaint alleges violations of the antifraud provisions of the Securities Act, the Exchange Act and the Advisers Act. The case is in litigation.
SEC v. Fraser, Case No. 2:09-cv-00442 (D. Ariz. Filed March 6, 2009) named four former officers of CSK Auto Corporation as defendants — two former senior officers, Martin Fraser and Don Watson, the former controller Edward O’Brien and a former supervisor Gary M. Opper. The complaint claims that from 2002 to 2004 the defendants engaged in an accounting scheme to inflate the financial results of the company essentially by failing to write-off vendor allowances which could no longer be collected as discussed here. As a result, the financial statements of the company were falsified. The case is in litigation.
SEC v. Barnett, Civil Action No. 1:09-cv-00457 (D.D.C. Filed March 9, 2009) is a settled financial fraud case brought against Allen Barnett, the former CEO and Thomas Stiner, the former CFO of AstroPower, Inc., a defunct manufacturer of solar electric power products. Defendants Barnett and Thomas are alleged to have directed the improper recognition of approximately $4 million in revenues from four transactions in the second and third quarters of 2002 as also discussed here. To resolve the case, both defendants consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records provisions of the federal securities laws, barring them from serving as officers and directors and requiring them to pay civil penalties. Mr. Stiner also agreed to settle an administrative proceeding in which he would be barred under 102(e) from appearing or practicing before the Commission as an accountant.
Quest Software, Inc. The SEC filed an option backdating complaint against software manufacturer Quest Software and three current or former officers, chairman Vincent Smith, former CFO John Laskey and former controller Kevin Brooks. According to the SEC press release, the defendants backdated options from 1999 through 2002. As a result the company reported a $113.6 restatement. All of the defendants settled, consenting to the entry of injunctions. Mr. Smith also agreed to pay a penalty of $150,000; Mr. Brooks agreed to pay a penalty of $60,000; and Mr. Laskey agreed to pay a penalty of $50,000. Mr. Brooks also agreed to pay disgorgement of about $34,000, prejudgment interest and to be suspended from appearing or practicing as an accountant before the Commission for a period of five years.
In the Matter of Merrill Lynch, Pierce, Fenner, & Smith Inc., Admin. Proc. File No. 3-13407 (March 11, 2009). This is a settled administrative proceeding against Merrill Lynch based on the failure of the firm to have adequate procedures regarding its “squawk box” as discussed here. According to the Order for Proceedings, the firm did not have adequate procedures to prevent day traders from overhearing and using material non-public information regarding unexecuted institutional orders that were being transmitted internally over the firm’s squawk box. This permitted those who overheard the order flow to trade ahead of the customer orders and in many instances to profit from the price movement following the execution of the customer orders.
To resolve this matter, the Commission accepted the settlement offer of Merrill Lynch. Based on Merrill’s consent the SEC directed the firm to cease and desist from committing any violation of Section 15(f) of the Exchange Act and Section 204A of the Advisers Act. Merrill was also censured and ordered to pay a civil penalty of $7 million. As part of the settlement, Merrill implemented a series of procedures. Those procedures are designed to restrict and maintain the confidentiality of client information transmitted over the squawk box.
Ponzi schemes. While these fraudulent schemes were once considered difficult to detect, the SEC seems to have found a way to identify them recently. Last week the SEC filed three more cases based on allegations that the defendants engaged in Ponzi schemes:
• SEC v. Smart, Civil Action No. 2:09-cv-00224 (D. Utah Filed March 12, 2009). The complaint, based on alleged violations of the antifraud provisions, claimed that defendant Brian Smart and his fund, Smart Assets, LLC, operated as a Ponzi like scheme, raised about $1.68 million form investors. The SEC obtained a freeze. The case is in litigation.
• SEC v. Donnelly, Civil Action No. 3:09CV0015 (W.D. Va. Filed March 11, 2009) is an action filed against John Donnelly and his firms Tower Analysis, Inc., Nasco Tang Corp and Nadia Capital Corp. The complaint alleges that Mr. Donnelly fraudulently raised over $11 million from about 31 investors. The SEC obtained a temporary restraining order based on its fraud allegations. The case is in litigation. See also CFTC v. Donnelly, Civil Action No. 3:09-cv-00016 (W.D.Va. Filed March 11, 2009).
• SEC v. Vassallo, Case No. 2:09-CV-00665 (E.D. Cal. Filed March 11, 2009) was filed against Anthony Vassallo and Kenneth Kenitzer. The complaint alleges a Ponzi scheme in which defendants raised over $40 million from about 150 investors. The SEC obtained a freeze order. The case is in litigation.